Evaluating the revenue recognition practices undertaken by the software company - Assignment Example

Running head: EVALUATING THE REVENUE RECOGNITION PRACTICES UNDERTAKEN BY THE SOFTWARE COMPANY Accounting for Corporate Accountability Name Abstract Isoft company announced that they were revising their previously published accounting numbers so that to show 174m less revenue than had been reported in the accounts of previous years. The software company made this announcement on August 25, 2006. This shows that the software company had overstated their revenue with 174m. For this case, they need to bring this revenue down so that they can show the stakeholders the true financial statements according to the laid down rules in the International Accounting Standards. There are various accounting concepts and principles that were not adhered to by Isoft company thus why they showed higher revenue than they had actually realised. This paper will critically evaluate the revenue recognition practices which had been used by Isoft and it will also include an analysis of the potential economic and social consequences of these practices. Revenue Recognition Practices In recording of income in the income statement, understanding and following the principles underlying its recognition is inevitable. For once, revenue should be earned. This means that anticipated incomes also referred to as receivables should not be recognized until such a time when they have been realized. According to the American accounting association, the term income includes realized net income add and not income only. Isoft Ltd might have overlooked this prudence concept regarding income. (Lynn, 2004) Even if the income elements are expected in the normal course of operations of the firm, a degree of judgement and probability need be attached in making the final conclusion on whether or not to include that income or else the turnover shall be overstated if that income does not materialize. Such items may include doubtful debts, exaggerations of the useful lives of some plant and equipment, etc. Apart from the probability of earning the income so anticipated, recognition as to whether that income should be able to be measured reliably should also be taken into account. Income recognition practices require that income should be measured reliably and with certainty. And if Isoft did not make reasonable estimate, then the whole items of income should have been excluded from the financial statements all together. However they should have included/shown the existence of the income items as a footnote to the accounts. (Wood and Sangster, 1999) Also related to the measurements is the cost at which a firm records its expenses which will have a direct influence to the recognized income. Isoft might have understated their reliability and expenses which is not prudent Another principle of income recognition is that of distinguishing revenue incomes from capital gains. Revenue incomes are those incomes generated from the principle income generating operations of the firm whereas capital gains are those gains made as a result of investments and or even disinvestments. Isoft might have included such capital gains as: Proceeds from sale of assets and Gains on disposals of plant and equipments in its income statements thus overstating revenue. This is a fundamental error that normally arises as a result of poor accounting knowledge on the side of accountants. The income recognition practices stipulate that only revenue incomes should be recognized in the income statements, capitalizing the capital items. 1 It should also not be forgotten that revenues should be matched with cost/ expenses incurred in realizing that income. Isoft did not employ clear cut-offs in apportioning of income and expenses to various financial problems. For instance, they might have wholesomely recognized a given income say rental income, some of which might have been rent in arrears for prior periods for previous debtors for earlier years making good their payments this year. For this case, Isoft should have only recognised rental income that pertain the current financial year into which the financial statements are prepared but not the arrears paid of the previous years. (Lynn, 2004) In these two circumstances, it can be noted that Isoft has predated all prior incomes to the current year. The readers/users of the financial estimates would be mislead by thinking that Isoft has made more revenue in the current year but the true picture being that the matching concept has been overlooked in recording of income. Only income that pertains the current year should have been recognised. (Wood and Sangster, 1999) Isoft's revenues could have been overstated owing to the company's failure to adhere to chapter 486 section 147 of the Company laws that requires that every company shall cause to be kept in the English language a proper books of accounts with respect to all sums of money received and expended by the company and all matters in respect of which the receipts and expenditure takes place and "all sales and purchases of goods by the company". (Accounting Standards Board, 1999) The company might as a result of bending the above law requiring that all sums of money expended shown in the books, failed for instance to tax some taxable elements of the income statements. This implies that the income items could have been overstated and by extension the overall revenue. These untaxed items might have made revenue to increase where in the actual sense; it should have reduced thereby showing revenue of 174 more than the actual amount. (Thomsett, 2001) There also has to be a faithful representation of income in the income statements for it to be reliable. For this case, information must represent faithfully the transactions and other event it either purports to represent or could reasonably be expected to represent. It happens at times that a company might resort to window - dress its financial statements to please investors especially when they are in financial bleak. It can achieve this by overstating certain revenue items as hiding some expenditure items. This contrasts the principle of faithful representation. By showing more income in their financial statements to woo investor, they contrast the faithful representation principle. This could have been one of the reasons as to why Isoft had overstated their revenue to please investors. It is a revenue recognition practice that all incomes must be complete. This is meant to achieve both reliability of information. It beats logic when for instant materiality is adhered to with regard to expenses and discarded when it comes to revenues. So even immaterial revenues should not be included to the accounts and this is what I soft could have done. Including recognizing even gifts, loan advances and donations as revenues. Such incompleteness then causes information to be false or misleading, unreliable and deficient in terms of its relevance. For this case, items such as donations, gifts and loan advance should not be included as incomes as this will off course overstate the revenue. Isoft might have included these items in their income statement thereby overstating their revenue. 2 But in revising the revenues downwards, Isoft must take care not to violate the same principles of recognizing income. For instance, they ought to desist from acts that could lead to overstatement of expenses so as to bring down the figure of revenues by 174M. By so doing, they might start including capital expenditure items into the income statement or even wrongfully consider genuine revenue incomes as capital gains with the aim of reducing turnovers. This will not help in solving the problem. Instead they should critically analyze the income statement for possible principles violated. (Wood and Sangster, 1999) Isoft could also have included notional incomes in their income statement. According to the accounting concept of income, notional incomes such as appreciation in the market value of the assets of the firm cannot be taken as business income unless the assets have really been disposed off. For instant, if the company owns a premises or a piece of land, and actual the market value of that item has increased, they are not supposed to adjust the value of that asset upwards. The real market value of an asset can only be shown or adjusted upwards if it has been disposed. For example, in the books of account, a piece of land had been indicated to be worth 20m, and it is disposed for 35m, then the new figure can be should in the books since the asset has been disposed. Another revenue recognition practice is the of "the separate entity concept". According to this concept, the business and the proprietor are taken as two different persons. Isoft might therefore have included individual person's incomes in the income of the company. For instance, the proprietor of Isoft made some more investment to the firm from his personal money and failed to adjust this as additional capital. For this case, if an additional capital is added to the firm, it has been adjusted accordingly instead of increasing the revenue. (Lerner and Cashin, 2001) Income is also subject to the going concern concept. An assumption has to be made that the business will not curtail its operations in the foreseeable future i.e. it will continue to exist. Because of this, depreciation should be based on the original cost and not on the asset's market values. In situations of inflationary economy, charging of depreciation on the basis of original cost of the fixed assets while taking revenue on the basis on the current market prices may result inconsiderable overstatement of business income. For this case, depreciation should be charged on the basis of the original cost instead of the real market value of the asset. It would be immaterial to charge more depreciation to an item just because the market value of that item has increased and vice versa. This could have led to overstatement of revenue by Isoft, as they might have charged less depreciation to some of their asset after basing the depreciation on the market value as it might have reduced instead of basing it on the original value of the asset. Lastly, Isoft had not applied the concept of consistency in income determination. According to this concept, a firm should be consistent in the accounting practices it employs in determining the value of assets, liabilities revenues and expenses. (Lerner and Cashin, 2001) Inconsistencies like frequent changes in depreciation, stock valuations will lead to variations of reported incomes and distorting of results. Annual Report That goodwill impairment write-off resulted into a loss for 2006 financial year. The accounting policy used in writing off the goodwill should be reviewed to check whether the amount of goodwill written of was overstated. A good accounting policy should have the following features: Consistent: In changing the accounting policy of recognising goodwill, the value taken as impairment written off should not deviate so much from the norm. Circumstances: The policy should be well accommodated by the surrounding circumstances. They should revise and decide which of the two methods i.e. straight line and reducing balance to use. The policy should be a policy that is generally accepted by the international accounting standards. But even if the write-off of goodwill results into a loss should be reported in the annual report since financial statements must adhere to the reporting framework and shows a true and fair view of the results of operative as shown in the income statement and of the financial position of the firm as shown in the balance sheet. The current share price of the firm is likely to decline because of the loss that is to be reported in the year 2006. This is owed to the loss of investors' confidence since no investor would wish to invest in a loss making entity. By extension, low demand of the shares of Isoft would translate to low price of the shares. If Isoft has for instance to change the accounting policy of goodwill impairment, then the management must adhere to the matching concept and write-off revenue for 2006 only against the impairment that was used to earn the revenue for 2006. By doing so, then the results might report a gain and hence maintain its share price. Potential Economic and Social Consequences The overstatement of the revenues by 174M will simultaneously result in an increase of profits by a similar figure. Then the question is what overstated profits will imply. Economically; 1. The information would give false information as to the gross domestic product especially if other firms make a similar mistake or attempt of overstating its sales. This might have a greater impact in our economy in the longrun as it will continue to show wrong gross domestic product. 2. It will stretch the company's financial resources because it means that the company will be taxed highly. Taxing the company higher taxes then it means that the company might be forced to pay high dividend to its shareholders. This might force the company to strain such that it might not have anything left for retained profit. Socially; 1. It might lead to social unrest in the company. Employees normally compare whether the company's profits commensurate with what they earn. They may therefore resort to strikes demanding salary hikes. The result might cause a lot of problems for the company such as: losses; sacking; delayed production; bad reputation of the company and even closing down of the company. 2. The information will hoodwink and mislead potential investors who might attempt to invest in Isoft on the basis of its "impressive" performance. This would lead to a bad reputation for the company, more so if the potential investor realises that the company has been overstating it revenue to woo them. They might not have any faith in the company and might even withdraw their shares from the company. 3. Customers who relied on the products from Isoft company might change their mind about purchasing anything from them in future due to the problem of deliberate overstatement of their revenue. Clients have a tendency of associating themselves with reputable organisations that are not only producing quality goods to the market but those that are concerned with the social welfare of its citizens. This would lead to low sales and eventually closing down of the company. References Alexander, D., Britton, A. and Jorissen, A. (2005): International Financial Reporting and Analysis, Second Edition, London: Thomson Accounting Standards Board, (1999), Revised Exposure Draft - Statement of Principles for Financial Reporting, ASB Publications. Amico New Zealand Limited (2006): Financial Reporting Act 1993, Amico New Zealand Limited, Wellington AT Foulks Lynch (1998), Drafting Financial Statements (Industry & Commerce), London, AT Foulks Lynch Ltd. BPP, (1998): CAT Interactive Text - Drafting Financial Statements, London, BPP Publishing Ltd. Deegan, C. and Unerman, J. (2006): Financial Accounting Theory: European Edition, Maidenhead: McGraw Hill Elliott, B. and Elliott, J. (2006): Financial Accounting and Reporting, Eleventh Edition, Harlow: Prentice Hall Lerner, J. and Cashin, J.A (2001): Business and Economics, New York, Mc Graw Hill Publishers Lynn C. (2004): Dynamics of Profit Focused Accounting, New York, Ross publishers Thomsett M.C. (2001): Builder Guide to Accounting, London, Craftsman publishers Wood F., and Sangster A., (1999): Business Accounting I, London, Financial Times Professional Ltd. Read More